How the Decoy Effect in Trading Skews Your Risk & Reward Perception

How the Decoy Effect in Trading Skews Your Risk & Reward Perception - Table of Contents

The Decoy Effect is a well-documented psychological bias that subtly manipulates decision-making by introducing a target option that makes one of the other choices appear significantly more attractive. This subtle manipulation was first introduced in a 1982 study as the “Asymmetric Dominance Effect” and is now widely used in consumer choice strategies, pricing models, trading psychology, and decision-making contexts.

For example, consider a coffee shop offering three size options: a small-size option for $3, a large-size option for $7, and a middle option for $6. Suddenly, the middle option seems like a preferred choice, even if you hadn’t planned to buy it. That’s because it is framed as the superior option when compared to the original options.

This effect is not just a quirk of consumer decisions; it extends far beyond everyday purchases and into financial decision-making. As highlighted in a 2023 research journal, businesses leverage this bias to steer customers toward higher-priced products, a strategy that also plays out in investment decisions, subscription plans, and stock trading.

How the Decoy Effect Impacts Trading Decisions

The Decoy Effect shows up in investment strategy in multiple ways, often leading traders to make choices that aren’t in their best interest. Here’s how it happens:

1. Stock Selection Based on “Comparison” Instead of Strategy

Imagine a trader choosing between two stocks:

Stock A: Strong fundamentals, high growth potential, but an expensive option.
Stock B: Moderate growth, slightly riskier, but cheaper.

Now, a third stock (Stock C) is introduced into the mix:

Stock C: High risk, poor fundamentals, but slightly cheaper than Stock B.

Even though Stock A is the logical choice, the introduction of Stock C makes Stock B appear more attractive, even though it’s still an inferior option. The trader’s rational analysis is compromised because Stock C distorts the decision-making process.

2. Choosing Between Trading Systems

A trader evaluating two investment strategy models might initially see:

System X: High win rate, moderate risk, $2,000 price.
System Y: Slightly lower win rate, lower risk, $1,500 price.

A third system (System Z) is introduced:

System Z: Worse win rate than both, higher risk, priced at $1,400.

Even though System X was the preferred option, the introduction of System Z makes System Y look like a more attractive option, even though it may not be a comprehensive option for long-term profits.

3. Decoy Effect in Brokerage Fees

Brokers often use the Decoy Effect to push traders toward certain subscription plans.

Plan A: $5 per trade, no monthly fee.
Plan B: $3 per trade, $50 monthly fee.
Plan C: $4 per trade, $40 monthly fee (decoy price).

Without Plan C, a trader would simply compare Plan A and Plan B and pick what’s best for their trading volume. But by introducing Plan C, brokers subtly push traders toward Plan B, even if it may not be the preferred choice for their actual trading frequency.

The Role of Trading Systems in Mitigating the Decoy Effect

The Decoy Effect preys on consumer preference, subtly nudging traders toward pricier options that may not be in their best interest. However, those who rely on systematic trading strategies can largely sidestep this cognitive trap. Here’s why:

Rule-Based Execution: Trading systems operate on predefined criteria, ensuring that decisions are made based on investment decisions rather than momentary biases.
Backtesting for Objectivity: By evaluating strategies using historical data, traders can verify that their approach is sound, reducing the likelihood of being swayed by decoy strategy tactics.
Disciplined Risk Management: Position sizing and pre-set risk parameters prevent traders from making compromise effects, reinforcing consistency over speculation.

Market noise and brokerage recommendations often create false signals that can lead to preference reversal. By adopting a data-driven approach, traders can filter out irrelevant information, stay focused on strategy, and make informed decisions

Challenges Systematic Traders Face with the Decoy Effect

Even systematic traders are not immune to the Decoy Effect. Here are some challenges they may still face:

Selecting Trading Systems with Decoy Influence: Many traders evaluate multiple systems but end up choosing one based on how it looks in comparison to others rather than its actual storage capacity for long-term gains.
Changing a Trading System Due to Comparison Traps: Some traders switch systems because a new system looks better relative to a target choice, even though their existing system is profitable.
Overcomplicating a Portfolio: Some traders feel the need to add extra systems or combination options just because they’ve been presented with a decoy price instead of keeping their approach simple and effective.

Actionable Tips for Overcoming the Decoy Effect in Trading

Want to beat the Decoy Effect and make objective, profitable trades? Use these practical strategies:

Define Your Criteria Before Evaluating Options: Before choosing a stock, system, or package deal, decide exactly what you need and don’t let choice overload distort your decision-making.
Backtest Trading Decisions: Use backtesting to test whether your investment decisions are profitable instead of letting phantom decoy effects trick you.
Remove Irrelevant Choices from Your Evaluation: If an option doesn’t fit your investment strategy, remove it from consideration completely. Don’t let it influence your real choices.
Use a Predefined Trading Plan: Make all trading decisions based on a written plan and not on how choices are presented to you.
Get an Accountability Partner: Having someone review your decisions can help eliminate attraction effects and keep you focused on objective, system-based trading.

Frequently Asked Questions About the Decoy Effect in Trading

Can the Decoy Effect really cause losses in stock trading?

Yes. Traders who pick stocks or systems based on decoy pricing strategy rather than real merit often choose suboptimal options, leading to poor results.

How can I tell if I’m falling for the Decoy Effect?

If you feel more confident in a decision task simply because of how choices are framed rather than actual data, you might be falling for this bias.

Is there a way to eliminate the Decoy Effect entirely?

While it’s hard to eliminate biases completely, using strict decision-making styles and backtesting can significantly reduce its impact.

Do professional traders also fall for the Decoy Effect?

Yes. Even experienced traders can be influenced by it. However, professionals rely on rigid trading systems and human decision-making models, making them less susceptible.

Conclusion: Beat the Decoy Effect with Proven Trading Systems

The Decoy Effect can subtly trick decision-makers into making poor investment choices, leading to lower profits and inefficient decision-making. But the good news is: you don’t have to fall for it.

At Enlightened Stock Trading, we provide the tools and investment strategies to ensure you stay on track. With The Trader Success System, you’ll develop confidence in a portfolio of proven trading systems, eliminating the temptation to second-guess your decisions based on choice in context.

To learn more about how our program can help you overcome psychological biases and achieve lasting trading success, apply to join The Trader Success System here.

DISCOVER THE LAST TRADING COURSE YOU WILL EVER NEED - THE TRADER SUCCESS SYSTEM

Trading Psychology and Psychological Bias Articles

To dive deeper into how other psychological biases affect your trading psychology and decisions as well as practical ways to overcome them, explore the articles below. For a comprehensive guide on mastering your mindset and building a resilient psychology, visit our Trading Psychology page.

Adrian Reid Founder and CEO

Adrian is a full-time private trader based in Australia and also the Founder and Trading Coach at Enlightened Stock Trading, which focuses on educating and supporting traders on their journey to profitable systems trading. Following his successful adoption of systematic trading which generated him hundreds of thousands of dollars a year using just 30 minutes a day to manage his system trading workflow, Adrian made the easy decision to leave his professional work in the corporate world in 2012. Adrian trades long/short across US, Australian and international stock markets and the cryptocurrency markets. His trading systems are now fully automated and have consistently outperformed international share markets with dramatically reduced risk over the past 20+ years. Adrian focuses on building portfolios of profitable, stable and robust long term trading systems to beat market returns with high risk adjusted returns. Adrian teaches traders from all over the world how to get profitable, confident and consistent by trading systematically and backtesting their own trading systems. He helps profitable traders grow and smooth returns by implementing a portfolio of trading systems to make money from different markets and market conditions.

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